A Better Way to Size Up a Company
Inquiring investors quickly run up against a serious limitation in the single most familiar tool used by stock analysts: the price-earnings ratio. Consider the current p-e's of two well-known rivals, J.C. Penney and Sears (S ) Roebuck. The other day, Penney's p-e was 19 and Sears' was 9.5. So buying stock in Penney must have been twice as costly as buying a stake in Sears, right?
If you doubt the utility of that conclusion, you're ready for a better way to size up companies and how their stocks are priced on Wall Street. It's called "enterprise value." Enterprise value, or EV for short, measures how much capital it would take to buy an entire public company. It can help you cut through a lot of the clutter -- in the case of Sears and Penney, far different balance sheets -- that can quickly render p-e ratios meaningless. "Enterprise value takes a broader view," says Peter Temple, a former securities analyst and author of a new book, Magic Numbers for Stock Investors (John Wiley & Sons, $29.95). "You could have two different companies in the same industry, making the same profit, but one would have a lot of debt and the other none at all." By looking through the lens of enterprise value, he adds, "the company with no debt would look cheaper."
Enterprise value doesn't appear in such investment classics as Benjamin Graham's and David Dodd's Security Analysis, but the ideas behind it do pop up in some of Warren Buffett's early letters to investment partners. The term didn't appear in either BusinessWeek or The Wall Street Journal before 1991.
So, precisely what is enterprise value? Simply stated, EV is the sum of a company's stock market capitalization plus its net debt. Stock market capitalization is a company's total shares multiplied by its stock price, and net debt is a company's total debt, minus its holdings of cash and marketable securities.
BUYING OUT DUPONT (DD )
In the diagram "Adding Up Enterprise Value", you can see just how EV is derived from financial statements. Suppose you wanted to find the EV of chemical giant DuPont. What would it cost you to buy it out? First, you would have to pay for all of the company's shares. With the stock at $41 and a billion shares outstanding, that comes to $41 billion. Next, you would have to add in the debts you would be assuming by taking over the company. DuPont has $5.9 billion in short-term debt, plus another $5.5 billion in long-term debt -- a total of $11.4 billion. With ownership, however, you also would get control of DuPont's cash reserves, $4.1 billion worth at last report. In theory, then, you could use DuPont's cash to pay off part of its debt, leaving $7.3 billion in net debt. Add that to DuPont's $41 billion in total stock market value, and you get $48.3 billion. That's DuPont's EV, or how much capital an imaginary buyer would need to own it free and clear.
Unless you're rich as Croesus and on a shopping spree, knowing a company's enterprise value won't help you much. You can learn a lot more by comparing EV to a measure of the company's earnings, much as a p-e ratio relates stock price to earnings. In this analysis, it's important to use earnings before interest and taxes, often called EBIT. The reason is that enterprise value assumes you've already paid off the company's debt and used its cash balances so there would be neither interest costs nor income.
To see how such a comparison might work, let's return to Sears and Penney. At $45 a share, Sears has a stock market value of $13.4 billion and a p-e ratio of 9.5. But because its balance sheet is laden with $29 billion in net debt, its EV comes to $42.4 billion, or nearly 13 times its $3.3 billion in EBIT. By contrast, Penney at $23 a share has a market value of $6.2 billion and a p-e ratio of 19, twice as high as Sears's. But because Penney owes a lot less -- its net debt is under $3.2 billion -- its EV comes to $9.4 billion and its EV-to-EBIT ratio is just 9.8. Seen in this fuller way, Penney, not Sears, represent the better bargain.
Another helpful exercise is to turn these figures upside down. Dividing EBIT by enterprise value indicates the percentage return that a theoretical buyer of an entire company might see. This percentage is sometimes called the "cash return" or "cap rate" for "capitalization rate," depending on which of several alternative profit measures -- EBIT, EBIT minus depreciation and amortization (EBITDA), or free cash flow -- that an analyst chooses to use in the numerator. What's it good for? Hummingbird Value Fund's Paul Sonkin uses cap rates to separate potential investments from poor-returning companies. As Sonkin puts it, "This helps me answer the question: 'If I could own the whole thing, would I want to own the whole thing?"'
Going back to Sears and Penney, Penney had the higher rate of return over the past four quarters. Its EBIT of $958 million divided by its $9.4 billion in enterprise value makes a return on investment of 10.2%. Work the same numbers for Sears and the past year's return comes to 7.8%. Likewise, you might compare DuPont and its rival, Dow Chemical (DOW ) Result: Dow in the past four quarters returned 3.7%, while DuPont saw 4.3%.
However enterprise value is used, its core strength is its ability to put companies with different capital structures on the same basis for analysis. What it won't do, of course, is foretell the future: How much will a company earn this year and next? Still, a rigorous application of EV analysis will tell you how much those profits are worth.
By Robert Barker